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The Cost of Capital

Name and Contribution: Shelly (B13114) - Determining the cost of debt Avishek (B13078) - Determining the cost of equity (Risk free rate and beta of the firm Srijan (B13116) - Cost of equity and holding period returns analysis Suprabhat (B13119) - Estimation of optimal capital structure by assigning appropriate debt to equity ratio Sarvesh (B13112) - Final Analysis and Conclusion

XLRI 2013-15

PROBLEM STATEMENT: 1. 2. 3. 4. Determining the cost of debt for Marriot Corporation Determining the cost of equity for Marriot Corporation (Risk free rate and beta of the firm.) Cost of equity and holding period returns analysis Estimation of WACC by assigning appropriate debt to equity ratio. (optimal capital structure). 5. Analysis and Conclusion

Problem 1. Determining the cost of debt for Marriot Corporation:

There are various ways of determining cost of debt for Marriot. a) Interest/Debt method b) YTM method if the instruments are listed c) Weighted average of different debentures based on their credit ratings and spread. Whether to use long term debt or short term debt for determination of cost of debt. A) In general, YTM method is most preferred if the instrument is listed on the stock market. But the issue here is that Marriot is involved in hotels and lodging business and hence the time period of projects are long ( approx. 5 years or even more). Add to this, the breakeven sales occur at even longer duration of time. In this long period, interest rates changes several times making YTM analysis inaccurate if interest rates go below initial cost of debt. Hence, considering the long term of Marriot projects, we dont consider YTM method for determination of cost of debt. B) Interest/ Debt method is not most appropriate here as we can observe that Marriot issues floating rate debentures to raise capital to garner better rating from agencies and also to increase its debt capacity in case of rising interest rates. Floating rate and nonfloating rate debts attract different rating agencies and hence interest/debt as a whole will give the wrong picture of true cost of debt. C) Third method is most appropriate as we can observe significant portion of debt portfolio consists of floating rate debts which attracts better credit ratings due to its less riskiness to interest rate changes. Floating rate debts have less spread over government bonds compared to non-floating rate debts. Calculation of Cost of Debt: lodging business have longer lives the cost of debt is calculated using long term government bonds ( eg. 30year govt bond) while short lived assets like contract services and restaurants should be calculated using short term govt bonds (10 year government bonds) Taking 30 year government bond rate - 8.95% ( for long term)

Taking 10year govt bond rate - 8.72% ( for short term) Lodging business: Also lodging business has highest component of better rated floating debts, its spread is lowest at 1.1% even though it contains highest debt/capital ratio among the three divisions. Cost of debt = 8.95% + 1.1%= 10.05% Contract Services: floating rate debt is 40% so spread is higher at 1.4% cost of debt = 8.72% + 1.4%= 10.12% Restaurants: only 25% of total debt is floating rate and hence spread is highest cost of debt = 8.72% + 1.80%= 10.52% Total cost of debt of organisation is weighted average of cost of debts of three divisions of the firm.

Problem 2. Determining the cost of equity for Marriot Corporation:

Determination of firm beta: Whether to choose from a) Top down approach b) Bottom up approach The firm should not rely totally on top-down approach because firm doesnt commit itself towards a stable capital structure as its debt equity ratio has swung wildly in 1980 and 1987. So it would be inappropriate to use top-down approach as it depends on market price variances of past years. Hence, it would be better to use bottom up approach by taking the weighted average of unlevered betas of different divisions of company by comparing with similar lines of business of other firms. Eg. Restaurant businesses can be compared with McDonalds (exhibit 3). Hotels business can be compared with Hilton hotels and Ramada Inns ( Exhibit 3). Calculation of appropriate Risk Premum: a) Government Bond returns - long term or short term? b) Whether to use Arithmetic means or geometric means? c) Risk premium using S&P returns. Using exhibit 4 and 5. Since major business of the firm has long term perspective, we use long term returns of long term government bonds. Say in our case from 1926-1987 As we are using long term rates, geometric mean is more appropriate. long term government bond return ( 1926-1987)= 4.27%

Standard & Poors 500 composite index return (1926-1987)= 9.90% Hence, risk premium = 9.90%- 4.27%= 5.63% Hence cost of equity using CAPM

= 4.27% +0.97 (5.63%)=9.71%

Problem 3. Cost of Equity (Ke) and Holding Period Returns AnalysisLong term US government bond returns Year (Rf) 1926-1950 4.04 1951-1975 2.22 1976-1980 1.69 1981-1985 16.82 1986 24.44 1987 -2.69 S&P's 500 Composite Stock Index Returns (Rm) Spread (Rm-Rf) 7.68 3.64 10.26 8.04 13.95 12.26 14.71 -2.11 18.47 -5.97 5.23 7.92

0.97 0.97 0.97 0.97 0.97 0.97

Cost of Equity (Ke) 7.57 10.02 13.58 14.77 18.65 4.99

Holding Period Return AnalysisCash Dividends 0.034 0.042 0.051 0.063 0.076 0.093 0.113 0.136 0.17 Market Price 3.48 6.35 7.18 11.7 14.25 14.7 21.56 29.75 30 Holding Period Returns 44.19% 83.13% 13.78% 63.49% 22.32% 3.79% 47.19% 38.45% 1.41%

Year 1979 1980 1981 1982 1983 1984 1985 1986 1987

Dividend Yield 0.98% 0.66% 0.71% 0.54% 0.53% 0.63% 0.52% 0.46% 0.57%

Capital Gains 43.21% 82.47% 13.07% 62.95% 21.79% 3.16% 46.67% 37.99% 0.84%

1) We can observe from the Holding period returns as mentioned above that Marriot stock has enjoyed considerable capital gains over the past few years. But, even though it has recorded good financial numbers in last 4 years, its return in 1987 is meagre 1.41% as capital gains have declined considerably. The reason for that could be changing capital structure of the

firm making it more debt burdened. Investors are not too confident about sharp rise in debt/capital ratio. However , the company still makes its buyback decision based on its warranted equity value and buyback of 13.6 million shares have stopped the stock prices to slide below its level. 2) We can see that if we consider the spreads of S&P index over government bond analysis, 5 years period might give erroneous data as the value fluctuates a lot in 1975-1980 and 19801985. So its suitable to take a longer duration analysis which suits our stock better as firm has long term horizon.

Problem 4. Estimation of WACC by assigning appropriate debt to equity ratio. (Optimal capital structure).
Summary : Marriots target is to fuel growth by optimisation of capital structure. For the purpose we need to assign weights to ease our calculation. Approaches: 1. First we decide which method to use for the purpose of market value. A) Book Value method is rejected because it is heavily deposed from market sentiments. B) Market value is rejected because of high variances causing problems in valuation. C) Target Value is the correct method because it provides a more accurate picture as it is very dynamic and self adjusting due to the activity in the market. 2. As it is mentioned in the case, Marriott has an option of determining what mix of debt and equity would determine the optimal use of debt. The debt to equity ratio was rejected and the choice was ultimately to use the interest coverage ratio because we are able to obtain a more realistic picture as to what is the firms capacity to handle debt based on its financial position. We calculated the interest coverage ratio over the 10 years. Interest coverage ratio = EBIT / Interest Expense Interest coverage ratio compared with Debt/Total capital over the years Year EBIT Interest Expense Interest Coverage Ratio Debt/Total Capital Ratio 1978 1979 107.1 133.5 23.7 27.8 4.519 4.802 37.5% 41% 1980 150.3 46.8 3.212 54.9% 1981 173.3 52 3.333 52.1% 1982 205.5 71.8 2.862 54.4% 1983 247.9 62.8 3.947 53.4% 1984 297.7 61.6 4.833 47.9% 1985 371.3 75.6 4.911 41.7% 1986 420.5 60.3 6.973 46.7% 1987 489.4 90.5 5.408 58.8%

Analysis : When we compare the values of the Interest coverage ratio over the years with the Debt/Total Capital Ratio, we find that even though we see that an improvement in the Coverage ratio in 1983 but the corresponding debt has not increases substantially. In 1985-87 however, company could not leverage huge improvement of to 40% improvement in coverage ratio and debt consisted only 47%

improving 15% over previous year. The next year, even though coverage ratio has taken a dip, the capital structure is heavily loaded with 59% debt. Conclusion : Marriott is constantly calculating warranted equity value for the purpose of market valuation. As a part of strategy if the stock price dipped below the warranted value, they bought back the shares. In our analysis, we find that this was not the correct strategy as their own warranted value does not truly tap into the market sentiments to know the correct value of stocks as a publicly trading company should. It might happen that company might grossly undervalue the stock and buy back inadvertent amount of stock. This might not be the best use of debt for the company.

Problem 5. Final ANALYSIS and CONCLUSION:

1) Marriots annual report stated that it is the most profitable company. For choosing its capital structure, Marriot uses interest coverage target as the main parameter. Accordingly, its debt equity structure varied wildly sometimes in the years. But when Marriot increases its debt capacity due to its floating rate debt structure and takes high levels of debts, the beta of equity increases. So, the confidence of the company in the market decreases and as can be referred from Exhibit 1, market prices of Marriot didnt increase because investors were unsure of Marriots future plans. 2) It affects Marriot another way. Since, it uses a warranty aided cost of equity and compares the P/E ratio of comparable firms (which are assigned by the market), it tends to repurchase its share as it did in 1987. With repurchasing, Marriot did manage to offset plummeting market prices by staying at a level it was in previous years. But, the use of such practices blocks working capital which can be used for financing any other lucrative project. 3) Company though uses interest coverage ratio as target multiple but it does not keep it at a constant level. This creates confusion in the market which observes debt/equity ratio. So company should probably try to fix its coverage ratios constant for better sentiments in market. 4) Higher floating rate debt is used for lodging business but the same can be done by restaurants business as well( currently 25% floating debt). This would help the firm get better ratings and hence lower cost of debt. 5) As observed from exhibit 4 and 5, spreads of S&P over last 7 years have been negative over the long term government bond returns. This indicates bad performance of stock over the past few years. However, stock prices of Marriot has soared over these years. So taking beta from past few years historical data might lead to erroneous results. Again, since the capital structure of the firm has varied heavily in 1987, estimating future cost of equity should be done by bottom-up approach. 6) Debt/capital ratio of stock has increased considerably in 1987due to rising debt and also because share prices have failed to increase in 1987. Along with buyback of 13.6 million shares, market value of equity has declined and hence equity/debt levels. 7) Since, exact weights of debt and equity are not known in the case we can assume WACC to be less than cost of equity (9.71% calculated). The firm is profitable at hurdle rates below 10% levels and hence can operate profitably. Also with hurdle rate being profitable, company can afford to increase its debt levels if need arises.